The King Of Hyper-Converged No Longer Has A Hyper Valuation

| About: Nutanix (NTNX)

Summary

Earlier this month, Nutanix reported the results of its fiscal Q2.

The results were somewhat in line although bookings were soft. The guidance did the shares in and led to a 32% decline in share price valuation.

The company has forecast a noticeable decline in sales force productivity in North America due to internal issues.

Some observers think the issue isn't execution but competition.

In addition, the company is facing short-term margin pressure from component price spikes of NAND and DRAM.

Nutanix - How long is the road to profitability?

Nutanix (NASDAQ:NTNX) has been one of the worst performing names so far in 2017, and as I write this, it is down almost 23% year to date. It is less than six months since the company went public and appreciated 130% on its first day of trading at the end of September 2016. Shortly thereafter, it made a high at $44/share, and for the most part, it has been tracking lower since that time. The company reported earnings at the start of this month, and the shares have fallen to the current trading range losing about one-third of their value in that time and more than 50% of their value since the high that was made back on October 3rd. The concern was guidance, which showed rapidly slowing sequential growth and a deterioration in margins. It is the second time that the shares have reacted negatively to an earnings release since the company had its public debut.

Should investors look at this as an entry point, or a name from which to stay far away? I think the valuation has reached a level that presents a reasonable entry point into the name and I think that competitive concerns, while hardly inconsequential, are more than discounted at current share price levels.

Nutanix, for those unfamiliar with the company, is a leader in what is called the hyper-converged space. Hyper-converged is a technology that has been developed over a bit more than the past decade that uses software to integrate compute, storage, networking and virtualization resources in a single box built around commodity hardware. That is, no doubt, a gross oversimplification for some. But the fact that multiple functions have been seamlessly integrated in a single box using commodity hardware is seen by some as revolutionary. It has dramatic impacts on the total cost of a data center and turning some of the economics of IT hardware on its head.

Currently, many observers and competitors of Nutanix suggest that hyper-converged infrastructure has been optimized for small data centers such as those run in the branches of large enterprises. While that may sound like a quibble, it isn't really. Nutanix is close to a $1 billion annual run rate in terms of revenues today. It is not likely to achieve continued hyper-growth status if it is unable to sell its solutions to large businesses for mission critical applications.

NetApp (NASDAQ:NTAP), in its most recent call, talked about building enterprise class hyper-converged products as though that was a virgin market. It is not an easy argument to decide, but it appears that Nutanix, even in a difficult quarter, has been able to penetrate a fair number of new Global 2000 nameplates and to do so by providing infrastructure with which to run mission-critical workloads.

For the most part, users buy hyper-converged infrastructure because of its advantages in terms of cost, reliability and the automation of a data center. It is also considered to be very "agile" in that it is designed to share resources so it can provide extra compute capacity to an organization both inexpensively and quickly. Most hyper-compute solutions have built-in security features, and the solutions are quite scalable with additions to capacity based on adding building blocks so that users buy what they need and do not need to buy capacity ahead.

Is Nutanix relevant?

There are two observations to make. Nutanix was, has been and remains a pioneer in the space, and any space that offers users so many advantages is likely to become very crowded very rapidly. The market for hyper-converged infrastructure is said to have a CAGR of 44% by one market research firm with revenues expected to balloon to $12.6 billion. Given that the overall markets for both servers and storage are growing minimally at best (at least in dollar terms), it not surprising to see every storage vendor and hardware vendor that is still above ground "converging" on this market.

The other thing to note is that what are called hyper-converged integrated systems are becoming mainstream and this will have the propensity to increase growth rates beyond what have been forecast. The Gartner note linked in the text talks about the evolution of use cases which have been quite specialized up till now but should become far more pervasive in the future.

For Nutanix, the major competitive struggles at this point appear to be with VMware (NYSE:VMW). Needless to say, conference calls are probably not the best cases to get objective judgments about the state of competition between the two vendors. For those who want a more in-depth analysis than I can provide, I recommend the following article linked above. It is fair to say, I think, that from the standpoint of technology, it would appear that Nutanix has the better part of the argument. But this is information technology and in that regard, it is not all that different from selling things like high-fashion sneakers - perception and style often count for more than technology. It is why it is rational for investors to be at least as concerned about sales execution as they are with whose solution can offer users the most effective solutions. I will simply say that by all appearances, the Nutanix Acropolis Hypervisor (AHV) despite its rather awkward name, appears to offer users more of what they want in a datacenter solution.

It is probably reasonable to expect that the Dell/Nutanix partnership will deteriorate over time. It is hard to be allied and partner with the parent of your greatest competitor indefinitely. But that has happened yet and it doesn't appear to be the reason behind the current sales setback.

And one can certainly wonder about just how far the partnership that Nutanix has with Cisco (NASDAQ:CSCO) can really evolve. There are going to be forks in the road at some point. But saying that does not imply that the forks to be seen are necessarily negative for Nutanix shareholders. It is at least as conceivable that Cisco, or another larger hardware vendor, winds up buying Nutanix as it is for Cisco to decide to compete all out in trying to displace Nutanix. The link above suggests that Cisco has tried to buy Nutanix twice; perhaps the third time will be the charm. I think it is hard to say, in the wake of Cisco purchase of AppDynamics, that almost any kind of acquisition is off-limits and this kind of transaction would surely make better strategic and financial sense than the transaction with AppDynamics has made.

Oracle (NYSE:ORCL) has approached the hyper-converged market with its Exa line of appliances that are optimized for various workloads. For Oracle, the strategy has not been successful, and it has been a perpetual share donor to Nutanix and to other hyper-converged vendors, in general.

So, Nutanix is having to compete for market share against organizations such as NetApp, Dell, HPE (NYSE:HPE) and Cisco that are multiples larger and have much to lose. The competition is likely to be messy and cut-throat. Further, as discussed below, some of the competitors, most noticeably Dell, are Nutanix customers.

In the last few months, there have been many announcements of products and consolidation in the space. Most notably, HPE has purchased SimpliVity, NetApp has promised an enterprise class system using the technology it acquired when it bought SolidFire, and AWS and VMware have announced a joint solution that may appeal to some users. At this point, Cisco is said to be unhappy with the performance of its HyperFlex product in the marketplace, which is often a precursor to some kind of strategic action. IBM (NYSE:IBM) is not involved in the space at this time. A take on the market and competition is linked to here from an industry trade publication, called The Register. As can be seen, it appears that Nutanix remains very relevant in this hyper-growth market despite all of the announcements.

At the end of the day, I would rather let management speak for itself in terms of how it looks at the market and let the reader decide whether or not the exposition rings true. Here are excerpts from the CEO answering the specific question on which hangs the question of Nutanix's future as a company and an investment:

"Because EMC owned VMware in the past as well I mean the sales managers the RD's (Regional Directors), the account managers…figure out what's the fastest product to retire (sic) their quotas and what's going to leave them the least friction in terms of repeat business…And on the SimpliVity front, if you take a step back, (IF) SimpliVity were really delighting their end users, it wouldn't have ended up the way it did…There was a reason why Cisco passed on them, even though they were close partners. …But we're absolutely not concerned about HP or Cisco or NetApp in terms of competition. They're not software companies with experience in building full stack operating systems that address compute and storage and networking and security and overall management."

If the CEO has made a persuasive argument on that issue, then the time to buy the shares depends on valuation and expectations. And for those who are unpersuaded, there is no reason to consider any other strategy but when to short them, they are still overvalued.

Unreasonable expectations of unreasonable performance

Nutanix was one of the pioneers in the hyper-converged space and started to be a factor in the marketplace at the start of this decade. Revenues have gone from zero to a current run rate of $700 million in less than five years. Profits…well, that is another story explored later in this article. The story across all typical sales metrics was fantastic…until last quarter. The company went public in late September and was one of the hottest IPOs of last year. The IPO was priced at $16 and before too long, the shares reached almost $47 intraday. At that price, the company had an enterprise value of more than $6.3 billion, which was more than 8.5X revenues. Obviously, investors had forgotten that Nutanix is a storage vendor and most storage vendors have EV/S of 2X or less.

The company is a very long way from profitability. Last quarter, despite the issues the company had with bookings and revenues, was the first to show a modicum of expense discipline, at least on a non-GAAP sequential basis, which is about the only way these companies can be analyzed.

The company's first public quarter which was announced the end of November of 2016 essentially achieved the results that had been expected and exceeded the levels that had been publicly forecast. Revenues increased 90%, 19% sequentially. Billings grew 87% and deferred revenues grew 160% year on year. The company generated a little bit of operating cash and had a slightly negative free cash flow. That said, the shares, after appreciating before the numbers were released, declined substantially because anticipation was greater than realization. But overall, the quarter didn't result in any dramatic negative share price reaction other than seeing a modest trend toward less outrageous valuation metrics.

The company forecast that revenues would grow 5% sequentially in Q2, which was considered a sandbag at the time. On the other hand, the forecast was an increase over the prior First Call consensus. Part of the reason for the modest forecast was the strength the company had seen in sales to the federal government. Federal business had dramatically seasonally based expansion during the closing of the government's fiscal year and it was expected to decline meaningfully sequentially. That did indeed happen, and just that way. The company enjoyed a strong quarter in its sales to Dell despite the EMC merger, an area of concern to most observers given that one of the key strategies of VMware. Now majority-owned by Dell, VMW is offering its own suite of virtualized hyper-converged solutions.

The company has also been developing an OEM relationship with Dell rival Lenovo (OTCPK:LNVGY), but that is far smaller in terms of revenue contribution at this point. The company didn't explicitly forecast bookings for the subsequent quarter but suggested that the relationship between bookings and revenues would gradually drift down to about 1.25X from 1.4X.

For the most part, in terms of operational performance, Q2 lived up to management's forecasts or was perhaps a bit better. Non-GAAP earnings were over the consensus and revenue beat modestly. GAAP gross margins rose a bit above the company's target range and reached 63%. That is a little bit surprising as many other vendors who use the NAND and DRAM had visible margin contraction during the quarter.

But GAAP operating expenses almost doubled year on year. That said, however, GAAP operating expenses did decline 16% sequentially, most of that being in the general and administrative category, which fell to a very reasonable 8.5% of revenues.

Billings came in at 125% of reported revenues, which is consistent with the kind of ratio trend forecast by the company. Billings fell by 5% sequentially, mainly reflecting a lower contribution from the company's Federal operations. It was this fall in sequential billings that was one of the precipitating factors in the share price debacle. Management ascribes the billings shortfall to a sales execution issue in North America. Clearly, there are alternative explanations that have more serious long-term implications.

The company sold 900 new name accounts, up from 700 in Q1. That is a good leading indicator of future business because of the company's land/expand model. Very few users jump into a hyper-converged architecture without some period of experimentation and operational proof of concept. Once they do, they can buy lots of hardware.

During the course of the call, the company talked about its efforts to develop solutions that would allow it to fully participate in industry trends toward public cloud usage. Nutanix isn't there yet and some observers have opined that it will never be there and that its future growth will be cut off by the cloud. It is an issue to be watched no doubt, and as mentioned above, the alliance of VMW and AWS is something that concerns this management but it hasn't yet started to change the competitive playing field.

Besides the bookings shortfall, described above, the real issue that drove the shares was guidance, which, for a company such as this, was quite unexpected and created serious problems for shareholders.

Overall, the company is now forecasting total revenues of $180-190 million in revenues. At the mid-point, that would represent sequential growth of less than 2%, although revenues would still be up by 60% year on year. There is a bit of negative seasonality in Q3 - it was visible a year ago, and two years ago, but the forecast is clearly below previously expected revenues levels.

As mentioned above, the company, like all other vendors who sell storage, is having to deal with higher DRAM prices which have spiked sharply in the last several months. While the company raised product list prices in an attempt to offset some of the increase in component costs, it has lowered its gross margin forecast by several hundred basis points.

And, as the result of lower revenue expectations, coupled with continued growth in operating expenses, operating cost ratios are going to noticeably increase compared to levels previously expected.

High stock price, missed bookings, a cloudy outlook for current quarter financial performance, the result was the 32% share price pullback seen in a couple of days in early March.

Some questions, some projections and some expectations

When a company like this misses and guides down and the share price implodes, many times, the knee-jerk reaction is to abandon the shares. I can't say I have never done that myself in my career as an analyst or as an investor. Even if one thinks the case hasn't changed, it is easier, often, to "go with the flow" and throw in the towel. Should that be the way to approach this name? I really do not think that to be the case.

One of the covering analysts, who had rated the shares as a hold when they were above $40, doesn't like them now that they are $20. There is more than a bit of chutzpah in that, given that her firm was one of the underwriters of the IPO, although this particular analyst has been ladling out that kind of fare for many years now. The other 17 analysts who report their ratings to First Call left their recommendations alone, and overall the line-up is evenly divided between buy and hold, but with an average price target 50% greater than current quotations.

The company suggested that much of its sales problem was self-inflicted. Again, pretty typically, it has promoted many of its top performing individual contributors to sales managers and has created multiple new territories. It is the standard playbook for companies like this. Sometimes, however, taking a great individual performer and moving him/her from the field to a management position has the impact of creating a hold in sales coverage. Whether that sorts itself out in six months as the company forecasts, or it takes longer as other observers feel is the case, is not something that can be proven at this point. On its side of the argument, management pointed to the company's strong performance in both EMEA and in APJ where it had not pulled individual contributors into sales management roles.

As mentioned earlier, the company, like all of its peers in the storage world, is being temporarily pressured by a component cost squeeze. I think that an investment decision beyond that of how to trade this name based on the cost of DRAMs is foolish. This company, as mentioned earlier, has raised list prices. Whether or not that will actually work is difficult to say. But, in a quarter or two, the DRAM/NAND shortage will reverse. It would be less than optimal to try to trade the shares of this company, or any other company such as NetApp or HPE, based on short-term cycles in component costs.

Finally, the company is likely to announce the early adoption of the new FASB 606 rule on revenue recognition earlier than planned. I do not think this is a good place for a lengthy and specific discussion of how 606 is going to impact this company. But the net is, according to the CFO, that gross margins will be several hundred basis points higher in the wake of the immediate adoption of the new rule. Looking out 6-12 months, it is quite conceivable that gross margins will increase by about 500-600 bps from the levels forecast next quarter and that operating expenses, particularly those in sales and marketing, could also show a noticeable improvement even larger than that of gross margins.

At this point, the current estimates for the quarter that ends 4/30 reflect management guidance both with respect to revenues and earnings and both of those estimates have been developed using the most conservative assumptions. Beyond the current quarter, estimates were noticeably reduced for the following quarter and indeed for the following year. It is those reductions that potentially set the stage for a succession of significant beat and raise quarters. I do not think that potential is valued in the shares at the current time.

Valuation

Valuing disruptive companies that have stumbled is never going to be an exact science. I have tried to lay out the case that what we are seeing here is a stumble and not a seminal detour - but there will be plenty of readers who think I have happy ears or that the impact of so many competitors is simply a risk they do not wish to deal with. Understood.

I have written on this company a few months ago, and at that time tried to provide some market potentials. This company talks about a potential $100 billion TAM in a few years. Most market research analysts, at least in their published reports, are a bit more conservative, but as hyper-converged becomes mainstream, the ultimate market size can be enormous.

I will just stick with a few traditional valuation metrics at this point. Over the next year, the company is forecast to reach revenues of $900 million. That seems quite low given the current quarterly progression but it makes sense to use the consensus I think. The company, at the current time, has 142 million shares outstanding, and Friday's closing price was $20.40 the market capitalization of around $2.8 billion. The company currently has a cash balance of a bit greater than $350 million, which puts the enterprise value at $2.45 billion. That yields an EV/S of 2.7X, no longer an outlier for a very fast growing company in its space. As many readers are aware, Nimble Storage (NYSE:NMBL) has recently announced an agreement to be acquired by HPE for $1.2 billion, which was a valuation of 2.5X enterprise value. Nimble had a growth rate of about half that of Nutanix and perhaps a far more difficult market space in which to compete.

As mentioned, Nutanix has no earnings and none are likely for the next couple of years. It is modestly cash flow positive, but no one is or should be buying the shares for cash flow generation. Substantially, more than all of its CFFO is coming from stock-based comp and that is not likely to change in the near future. The company is building deferred revenues because of its software sales, although that has been offset to a degree by the amortization of deferred commissions. Last quarter, the company had a significant benefit from the change in the fair value of its convertible preferred stock warrant liability and while that may continue this quarter, it is not a perpetual source of funds.

Despite the improvement in some of the expense ratios last quarter, management has forecast that there will be some noticeable backsliding in the sales and marketing expense ratio in the current quarter and probably beyond. The valuation for this company is a function of revenue growth and the revenue growth is a function of the company's competitive positioning in a hot space.

I certainly can't prove my expectations with regard to growth and the company's guidance is such that it has given itself a quarter or two in which to recover its ability to achieve sales execution. There are some who suggest that it is prudent to avoid the name until there is a palpable sign that it has overcome competitive headwinds. Other writers on this site have urged avoidance of the shares because of the lock-up expiration.

For my part, I think the possible acquisition of this company at a substantial premium simply can't be ignored and is likely to put a floor under the shares. Cisco needs what it has and probably realizes it. IBM ought to want what it has. And frankly, Oracle ought to abandon what seems a quixotic quest with regards to its Exa line of appliances in favor of trying to acquire this business. Of course, I haven't any idea that anything will happen in that regard for Nutanix - but it certainly seems to suggest that it is not unreasonable to enter the name at this point with the current valuation expecting to see positive alpha going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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